Its latest policy to keep interest rates near zero through mid-2013 could backfire and prevent home sales instead of encouraging them

Basic economic theory says that when mortgage interest rates are low, consumers should feel more encouraged to buy a home. But right now, that intuitive theory might not hold. Kathleen Madigan at Real Time Economics proposes that the Federal Reserve's latest proclamation -- that short-term interest rates would be kept near zero through mid-2013 -- might discourage home buying. Could this be possible?

When Certainty Can Hurt

This might seem like a backwards idea. To be sure, the last thing that the Fed would aim for is to make the housing market worse off. So why would it allow one of its policies to keep home sales artificially low? This might be an unfortunate and unintended consequence of its desire to calm the broader market.

The logic works here because home prices are declining. Nobody is sure how far they might fall or when they'll finally hit bottom. But we can feel fairly confident that prices aren't there yet. And what do we now know? Interest rates will be low for another two years. So why hurry to buy a home now?

Savvy potential home buyers who can wait the market out now have a good reason to do so. They don't have to worry about interest rates rising before the market bottoms. Instead, they can wait for the market to continue to decline. If it appears to bottom out in the next two years, then they can step in and finally buy at that time. But if prices keep declining over this period, then they'll be smart to buy in the first half of 2013, just before interest rates might begin rising. In the near-term, you might be better off waiting.

This actually makes a lot of sense. Prior to the Fed's August revelation, one of the best arguments for why it might make sense to buy a home in the near future was that interest rates will rise. As long as the Fed is holding them down, then this argument begins to disintegrate.

Some Reasons to be Skeptical

But there are a couple of reasons why the Fed's action might not endanger home sales.

Mortgage Interest Tracks Long-Term Rates

First, the Fed's action specifically targets short-term interest rates. They'll certainly be very low through mid-2013. But a 15-, 20-, or 30-year mortgage will face prevailing long-term interest rates. While short-term interest rates often have some influence over longer-term rates, the two aren't always directly correlated. In other words, we could see longer-term interest rates begin to rise even as short-term rates are kept low.

For example, in October, the government may no longer guarantee very large mortgages in some markets. That should cause their interest rates to rise a little, since banks and investors will add a default risk premium to those rates. These and other market shocks specific to housing or longer-term rates could still affect mortgage interest rates.

Home Price Movements Are Regional

Second, home prices may continue to decline nationally, but some markets will stabilize faster than others. Some already appear to be healing. So the question of whether to take advantage of low interest rates really depends on where you want to buy a home. In worse-off markets, it may be wise to wait. But in markets showing signs of recovery, low rates might make now the perfect time to buy.

Will the Fed's Words Do More Harm Than Good?

Are we seeing this theory in action? We actually might be. On Wednesday, the Mortgage Bankers Association revealed that mortgage purchase applications plummeted 9% last week to their lowest level in more than a year. While they explained the reason for this decline as general consumer nervousness, what if the Fed was partially responsible? It did, after all, announce its new policy on Tuesday afternoon last week.

If this counterintuitive theory holds, then the Fed might want to revisit its decision. The U.S. economy would benefit significantly if home sales began to rebound. Residential investment is providing very little support to the nation's economic growth at this time, and the construction sector remains one of the hardest hit by layoffs. Perhaps in this case, a little uncertainty could have been a good thing.

About the Author

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation.

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